WHEN companies need funds to grow, instead of borrowing from a bank they sometimes choose to sell a share in the company's ownership to investors.
These shares, represented by certificates of ownership, are referred to as equities.
For ordinary investors buying or investing in equities can be risky in the short term, but can be an extremely rewarding investment option for those who have time on their side and can handle the short-term ups and downs in the investment value.
Why should you invest in equities?
Actually, if you're not able to tolerate the possibility of losing some of your money in the short term, you should probably avoid investing in equities altogether, or only invest a small portion of your capital in this asset class.
But it is important to note that over the longer term, which is typically around five to 10 years, returns (growth) from equities can beat inflation and have proven to be higher than any other asset class, like bonds, cash and property.
For example, for the 10 years to the end of last November, our equity market returned 16,91percent a year, while bonds returned 12,87percent a year and cash delivered 9,85percent a year.
When you buy equities, you become a shareholder in the company and are eligible to receive a share of the company's profits in the form of dividends.
As an investor you could receive dividends as cash, or as free shares (scrip dividends), which are usually declared every six or 12 months.
These dividends make up part of the total return from an equity investment.
In addition, shareholders can sell their shares at any time, hopefully at a higher price to make a profit.
The increase in the price of equities is called capital appreciation, which makes up the remaining portion of the total return from equities. Supply and demand, positive perceptions of the company and a good profit influence the share price and dividend payout.
How do you acquire equities?
Most equities are bought and sold on a formal stock exchange, such as the Johannesburg Securities Exchange, where they are listed by public companies.
You can acquire them directly through a stockbroker, or by trading on an online share trading website.
You can also invest in equities indirectly through unit trusts, offered by a financial services company like Old Mutual. Equity unit trusts pool the funds of many investors and use the money to invest in a range of listed shares, with the choice of shares carefully selected and managed by professional fund managers. In exchange, the investor receives "units". If the underlying companies perform well, the values of these units increase.
What are the disadvantages of equities?
When companies encounter financial difficulties their share prices can go down.
Share prices are also affected by market sentiment, which adds to the ups and downs of the equity market and increases risk.
The 2008-09 market crash saw our local equity market lose over 30percent in less than a year - a good example of why those who cannot tolerate short-term losses should probably avoid investing in equities.
Another risk is that companies might choose to invest profits in further growth of the company instead of paying dividends. As a result, investors will not receive an income. These factors make equities risky over the short term, while being most effective over the long term.
Investing wisely in equities as part of an overall balanced portfolio can prove to be rewarding for investors who have time on their side and can handle some risk.
Some of this risk can be offset by allocating a portion of your investment across other, less risky asset classes like bonds or money markets.
A professional financial adviser can help you decide on the appropriate allocations.
And, if you do opt for some equity investments, a unit trust fund manager with a good track record for managing equities can play a role in helping you get good long-term returns above inflation.
lThe writer is head of distribution, Old Mutual Investment Group